- Presented by Ph.D Kwang-Ho Lee

I. IMPORTANCE OF INTERNATIOAL TAX SYSTEM

II. GENERAL ASPECTS OF TAX TREATY

III. STRUCTURE OF THE OECD MODEL

IV. MAIN DIFFERENCES BETWEEN THE OECD AND UN MODELS

V. FURTHER STUDIES ON IMPORTANT ARTICLES I. IMPORTANCE OF INTERNATIOAL TAX SYSTEM z With the advance of globalization , the world economy has been integrating as a single market ƒ MNEs has been expanding their territories in the world economy ƒ International movement of growth factors such as capital, technology and enterprises as well as goods and service has been highly increasing.

* World FDI Inward Flows: U$ 55.2bil. (1980) → U$ 201.5bil. (1990) → U$ 1.3tri.(2006)

z Globalization has affected on the environment of tax policy and systems as well as on the other areas.

I. IMPORTANCE OF INTERNATIOAL TAX SYSTEM

ƒ The international characteristics of tax policy has been increased with the so called “globalization” ƒ In the past the tax policy had been regarded as a typical domestic policy but no longer with globalization ƒ A tax policy of a country might result in spill-over effects on the economy of other countries z International tax competition has been emerged as one of main issues in the world tax area ƒ Competitively since the second half of 1970s main countries have been decreasing the tax rates of corporate and individual income tax. I. IMPORTANCE OF INTERNATIOAL TAX SYSTEM

z Ideally the single tax system with single jurisdiction worldwide could resolve manyyp problems resulted from different tax systems with different jurisdictions. ƒ But in the reality each country has different tax system because it is related to the sovereignty of each country

z In this situation each government in the world has been facing opportu nities and challenges to attract investment and human resources with high expertise to develop its economy ƒ The tax should not be obstacles for the promotion of international economic activities.

I. IMPORTANCE OF INTERNATIOAL TAX SYSTEM

z Risk of the double taxation on the foreign income without the relief system of double taxation ƒ Residence country has right to tax on world wide basis of the resident ƒ Source country has right to primarily tax on the source ifthincome of the non-residen t

z Risk of the excessive taxation on the foreign income ƒ Domestic tax law of most countries usually impose high withholding tax rates on the passive income of non- resident without tax treaties I. IMPORTANCE OF INTERNATIOAL TAX SYSTEM

z Different tax system of each country might provide rooms for tax avoidances ƒ MNEs could transfer the tax income to the region with lower tax rates by global transactions network ƒ Without international tax cooperation it’s hard to find appropritiate oversea t ax i ncome

z International tax cooperation and the vast networks of tax treaties have been gggpaining importance ƒ to support cross-border economic transactions ƒ to prevent from tax avoidance with thems.

I. IMPORTANCE OF INTERNATIOAL TAX SYSTEM

z Tax treaty is central parts of international tax system in which include;

ƒ RliffhRelief of the dou ble taxat ion ƒ Limited tax rates on the investment income of non- resident such as dividends, interests and royalties ƒ Transfer ppgricing ƒ Mutual agreement as a way to settle the international tax disputes ƒ Exchange of tax information

ƒ Int ernati onal t ax coll ec tion coopera tion: I. IMPORTANCE OF INTERNATIOAL TAX SYSTEM

z Other tools of internal taxation system

ƒ Controlled-Foreign Corporations(CFCs)

ƒ Thin Capitalization

ƒ Treaty shopping etc

II. GENERAL ASPECTS OF TAX TREATIES

HISTORICAL DEVELOPMENT OF TAX TREATY

z Long history back to 1890s

z Expanded networks post WW II

z OEEC + OECD : ™1956 study int’l double taxation ™1963 draft Model Tax Convention ™1977 Model ™1992 Model (loose-leaf to facilitate updates) ™updates ‘94, ‘95, ‘97, 2000, 2003, 2005, 2008

z UN Manual 1979 + Model 1980 ™Updated 2001 II. GENERAL ASPECTS OF TAX TREATIES

CHARATERISTICS OF TAX TREATIES

z Mostly bilateral international treaties

z Incorporated into domestic law

z Generally follow the structure of the OECD Model

z Variations to take account of requirements of the contracting countries

z Not powered to generate the tax rights but to limit that of the contracting countries

z Vast net work of t ax t reati es i n world : 2800

II. GENERAL ASPECTS OF TAX TREATIES

CHARATERISTICS OF TAX TREATIES

™ Tax or Not

Tax Law Tax Treaty Results

Tax Yes Tax No Tax No

Tax No Tax Yes Tax No

TYTax Yes TYTax Yes TYTax Yes II. GENERAL ASPECTS OF TAX TREATIES

PRIORITY OF APPLICAION OF TAX TREATIES

z KOREA, , Constitution > Tax Treaty > Tax Law

z USAU.S.A Constitution > Tax Treaty = Federal Law

z U.K. Constitution > Tax Law > Tax Treaty

II. GENERAL ASPECTS OF TAX TREATIES

Influential Organizations: OECD & UN III. Structure of the OECD Model

z OECD Model Convention has seven chapters: Chapter I Scope Of Convention(1-2) Chapter II Definitions(3-5) Chapter III Taxation Of Income(6-21) Chapter IV Taxation Of Capital(22) Chapter V Methods Of Elimination Of Double Taxation(23) Chapter VI Spp(ecial Provisions(24-29) Chapter VII Final Provisions(30-31)

OECD MODEL: SCOPE CHAPTER 1 (ARTICLES 1 ––2)2)

1. To whom does the treaty apply? ™To residents of the contracting states

2. Taxes covered ™Taxes on income ™Taxes on capital ™Taxes of central government and political subdivisions ™List of taxes ™Replacement and new taxes DEFINITIONS CHAPTER II (ART. 3, 4 & 5)

3. General definitions ™Person ™Comppyany ™Enterprise ™Enterprise of a contracting state ™International traffic ™Competent authority ™National ™Business ™Rule for undefined terms

DEFINITIONS CHAPTER II (ART. 3, 4 & 5)

4. Resident ™ Based on domestic law ™ Tie breaker rules for dual resident individuals and non-idiidlindividuals

5. Permanent establishment ™ Fixed place of business ™ Construction longer than 12 months ™ Activities deemed not to be P.E ™ Dependent agent with power to contract TAXATION OF INCOME CHAPTER III (ART. 6 –21)

6. Income from immovable property ™ Unrestricted taxation by source country allowe d(OECD, UN)

7. Business profits ™ Taxation of net profits by source country allowed to the extent that attributable to a permanent establishment therein ™Force of attractions(()UN) 8. Income from shipping, waterways transport and air transport ™ Exclusive taxation by the country where the place of effective management is located

TAXATION OF INCOME CHAPTER III (ART. 6 –21) 9. Associated enterprises ™ Right to adjust transfer prices ™ CdidjbhCorresponding adjustment by other state

10. Dividends ™ Taxation by source country limited to a certain percentage ™ 5% if the beneficial owner is a company(25%treshold) ™ 15% in all other cases ™ Dividends connected with PE applied by Art. 7 11. Interest ™ Taxation by source country limited to a certain ppg(ercentage (less than 10% ) ™ Interests connected with PE applied by Art. 7 TAXATION OF INCOME CHAPTER III (ART. 6 –21)

12. Royalties ™ Exclusive taxation by the country of residence ™ Payments for the use of, or the right to use industrial, commercial, or scientific equipment was deleted(1992) ™ Roy alties connected with PE applied by Art. 7 13. Capital gains ™ TtibTaxation by source coun tliitdtitry limited to gains on immovable property and business assets of a permanent establishment ™ Taxation by source country on gains from alienation of immovable property shares or participation shares ™Taxation by resident country on others 14. Independent personal services ™ [Deleted in 2000 update, now covered under article 7]

TAXATION OF INCOME CHAPTER III (ART. 6 –21) 15. Income from employment ™Taxation of employment income by source country biiflifbut exemption if employee is present for less than 183 days and the employer is non- resident with no PE

16. Directors’ fees ™Taxation by country of residence of company

17. Artistes and sportsmen ™Taxation by source country is allowed ™Taxation to the income accrue to another person TAXATION OF INCOME CHAPTER III (ART. 6 –21)

18. Pensions ™EliExclusive taxa tion btfidby country of residence ™ Pension under social security system shall be tbllithtaxable only in the source coun t(try(UN) 19. Government service ™Exclusive taxation by country for which the services are rendered (exception for nationals and persons who are already residents of the ooesae)ther state):

TAXATION OF INCOME CHAPTER III (ART. 6 –21)

20. Students ™PtftidtftdtPayments from outside country of study not taxable there 21. Other income ™Exclusive taxation by country of residence except if income relates to a P.E. 22.Capital ™Source country taxation allowed for Immovable property & business assets of a permanent establishment or fixed base ™Special rule for shipping: place of effective management ELIMINATION OF DOUBLE TAXATION CHAPTER V (ARTICLE 23) 23.Methods for elimination of double taxation ™Two alternative methods: ƒ Exemption method (art. 23 a) ƒ Credit method (art. 23 b) ™Exemption method ƒ Full exemption ƒ Exemption with progress ™Credit method ƒ Full credit ƒ Ordinary credit ƒ Indirect tax credit ƒ Tax sparing credit

SPECIAL PROVISIONS CHAPTER VI (ART. 24 –29) 24. Non-discrimination ™Non-discrimination on the base of nationals, PE or expenses-dddeduc tions 25. Mutual aggpreement procedure ™Present the case within 3 years from the first notification of the action resulting in taxation not accordance with the provisions of the Convention 26. Exchange of information ™For carrying out the Convention or domestic tax laws concerning taxes of every kind ™Confidential treatment : disclose only to persons or authorities(including courts) involved in the assessment, collection or appeal of tax and in the case of court rulings. SPECIAL PROVISIONS CHAPTER VI (ART. 24 –29)

27. Assistance in the collection of taxes(2003) ™No restriction by Articles 1 & 2 ™Only in the OECD Model

28. Members of diplomatic missions and consular posts

29. Territorial extension • No same article in the UN Model

FINAL PROVISIONS CHAPTER VII (ARTICLES 30 – 31)

30. EifEntry into force of fh the conventi on ™Date of entry into force ™Date of effect

31. Termination of the convention • BiiBy giving not ice o f term iiination at least 6 months before the end of any calendar year after the year ….. PROTOCOLS

z Provisions form an integral part of the CtiConvention

z Agreed at time of convention or subsequent

z Uses: ™Clarifications, deviations, updates and modification

IV.Main Differencies Between the OECD and UN MODELs

z Article 5(PE): ™ Construction regarded as PE is expanded (paragraph 3)

(OECD) A building site or construction or installation ppjroject …onl y if it lasts more than 12 months.

(UN) A building site, a construction, assembly, or installation project, supervisory activities in connex ion therew ith, bu t only w here su ch site, project or activities continue for a period of more than 6 months . IV.Main Differences between the OECD and UN Models

z Article 5(PE): ™(UN) DliDelivery omitte d from paragrap h 4(no PE) “… facilities soly for the purpose of storage or disp lay o f goo ds ….. ”

™ (UN) Paraggpraph 5 ()(b) is added on De pendant a gent which is regarded as PE “… habitually maintain in the first mentioned state a stock of goods or merchandise from which he regularly delivers goods or merchan dise on bhlffthbehalf of the en terpr ise ”

IV.Main Differences between the OECD and UN Models

z Article 5(PE): ™Insurance (paragraph 6) in UN Insurance enterprise except reinsurance shall be deemed to have PE if it collect premium or insures risks through a person other than an indeppgendent agent

z Article 7(Business Income) ™ Force of attraction rule in para.1 in UN (b) profits is attributable to sales of goods of the same of similar kind as those sold through that PE or (c) other business activities carried on ofiilkidthfPEf same or similar kind as those of PE. IV.Main Differences between the OECD and UN Models

z Article 7(Business Income) ™ Ro lya lties, itinterst sandfd fees b e tween PE and the head office of the enterprise are not allowed to th e d ed uc tion an d pro fits o f PE(UN para 3)

※ Commentary of OECD include same contents

™ No tax on the mere purchase by PE in OECD is deleted in UN.

IV.Main Differences between the OECD and UN Models

z Article 8(Shipping, inland, waterways transport and air transport) ™ UN include alternative “b” lim ite d source s ta te taxati on o f i nt ernati onal shipping in case that the operations is more than casual

z Article 10(Dividends) ™ UN: rate is not specified and ownership threshold is lower (10%) ™ OECD: rate is 5-15%, threshold is 25% IV.Main Differences between the OECD and UN Models

z Article 11(Interest) ™ UN: limited tax rate is not specified ™ OECD: rate is less than 10%

z Article 12(Royalties) ™ UN: source state(payer’s state) taxation is possible, rate is not specified, ™ OCOECD: resident state taxation only ™OECD: “the right to use industrial, commercial, or scientific equipment” is deleted in 1992

IV.Main Differences between the OECD and UN Models

z Article 13(Capital Gains) ™ OECD: source state taxation of shares if more than 50% of value of the alienated share is from immovable property ™ UN: rate not specified

z Arti c le 14(In depen den t Persona l Serv ices ) ™ deleted from OECD model(fixed base) ™ UN Model additional criteria: 6 month and amount threshold

z Article 16(Director’s Fees) ™ UN: extends scope(directors + high level managers) IV. Main Differences between the OECD and UN Models

z Article 18(Pensions) ™ OECD: ppyensioner resident state tax only

™ UN: two alternatives (A) pensioner resident state tax only (B) if the payment is made by a resident of the other contracting state, the other state taxable

™UN: Pension under social security system shall be taxable only in the source country

IV. Main Differences between the OECD and UN Models

z Article 21(Other Income)

™ OECD: resident state taxation only

™ UN: Other income arise from the other contracting state taxable in the source state

z Article 27(Assistance in the Collection of Taxes)

™ UN: no equivalent provision (2003 OECD addition) V. Further Studies on Important Articles

Resident: Article 4(Overview)

z paragraph 1 :“resident of a contracting state” is defined as a person who is subject to worldwide taxation in the state on the base of certain criteria

z paragraph 2 : tie-breaker rule for individual

z paragraph 3 : tie-breaker rule for other persons

Definition Of Resident: Article 4 (1)

z Based on domestic law: person is resident of a country if liable to tax in the country by reason of his: ™Domicile ™Residence ™Place of management ™Or similar criterion z But does not include someone who is taxable only on ifincome from sources itht(in the country (a non-residen t) z Residence in relation to a treaty may change at a point of time during a fiscal year, typically when a taxpayer's circumstances change Resident: Tie-Tie-breakerbreaker for Dual Resident Individuals (Article 4 (2))

Does the individual have a permanent home in one or both States? YES 1 NO Does he have a permanent home in the two He is a resident of the State where States? YES he has a permanent home NO Can the State where he has his center of YES vital interests be determined He is a resident of the State where he has his center of vital interests NO 2 YES Does he normally stay (“have an habitual He is a resident of the State abode”) in only one of the two States? where he has an habitual abode NO 3 YES He is a resident of Is he a national of only one of the two States? the State of which he is a national NO 4 The competent authorities will settle the case by mutual agreement 5

TieTie--breakerbreaker For Other Entities (Article 4 (3))

z OECD and UN Models adopt place of effective management ™ Where the keyyg management and commercial decisions are in substance made ™Ordinarily where the most senior person or persons (the bo ard?) make those decisions ™Where the actions to be taken by the entity as a whole are taken ™Look at all facts and circumstances z Common alternatives: ™ Place of incorporation ™ Mutual agreement procedure: zwith or without guidance zIf no agreement, taxpayer loses treaty benefits Rule in Article 7 (Business Profits)

zAllocation of taxing jurisdiction for bus iness pro fits (Ar t 7(1)): ™Business ppyrofits taxed exclusively in the State of residence of the enterprise unless there is a “permanent establishment (PE)” in the other State ™If a PE exists, profits attributable to the PE taxable in the PE State.

Rules in Article 7 (Business Profits) z paragraph 2 - primary rule for allocation of profits to a PE – profits the PE might be expected to make if it were a separate and independent enterprise z paragraph 3 – If one State adjusts the profits of the PE and taxes accordingly, the other State shall make an appropriate adjustment. ƒ When necessary – competent authorities shall consult each other z paragraph 4 - other articles have priority over Article 7 Profit allocation rules - Article 7 v. Article 9 zArticle 7 is concerned with transactions between parts of the same legal entity zArticle 9 is concerned with transactions between separate, but related, entities zBoth based on the arm’s length principle

QUICK TOUR OF ARTICLE 5 zPara 1 ppyrimary rule zPara 2 illustrative list of para 1 PEs zP3Para 3 construc ti/itlltition/installation pro jtjects zPara 4 activities not PEs zPara 5 dependent agents may be a PE zP6Para 6 idindepen dent agents not a PE zPara 7 control of a subsidiary not aPEofa PE of the parent A Fixed Place of Business PE zParagraph 1 of OECD and UN Models included in almost all tax treaties: “For the purposes of this Convention, the term “permanent establishment” means a fixed place of business through which the business of the enterprise is wholly or partly carried on. zEssential characteristic: Distinct "sites" , a fixed place of business, for sufficient duration

Condition 1: A place of business z Any premises, facilities or installation ™used for carryyging on the business ™whether or not used exclusively for that purpose z Space is at its disposal z Immaterial whether owned, rented or at the disposal of the enterprise - No formal legal right to use required ƒ Example 1 - mere presence is not sufficient ™ See salesman example (paragraph 4. 2) - No ƒ Example 2 - Use of an office by enterprise, for that enterprise's business - yes ƒ Example 3 - Truck loading bay visited regularly - No ƒ Example 4 - Painter works on a client' s building - Yes Condition 2: fixed place of business z Two cr itica l componen ts o f “fixe d”: ™a certain degree of permanence (the “duration test”) at each geographical spot ™a sppggpp(ecific geographical spot (the “location test” ) z Regardless of where a short term activity is carried on in the source state, if there is insufficient duration, there is no PE (same applies under the UN Model). z Guidance in the OECD Commentary: ™less than 6 months, probably not a PE ™6 to 12 months,,p possibl y a PE ™12 months likely to be a PE

Condition 2: fixed place of business z Temporary interruption of operations is not closure. z Rule for determining whether a PE exists, but some of the expenses incurred before the PE is established may be attributable to the PE. z If t here is no dist inct p lace - thhihen there is no PE(PE (even if long duration) z What is the extent of the location, (e.g.) a single office or various offices of a building? z Coherent whole commercially and geographically z A place regularly returned to: (e.g.) street market Condition 3: Carry on the business through the PE z Must carry on the business of the enterprise (wholly or partly) through the PE z To be given a wide meaning - any situation where business activities are carried on at a particular location at the disposal of the enterprise for that purpose

PARAGRAPH 2: EXAMPLES OF PEs

zExamples of typical fixed places of business ƒ Place of management, Branch, Office, Factory, Workshop, Mine, Oil or gas well, Quarry or any other place of extraction of natural resources zMust meet the requirements of paragraph 1 zNot exhaustive z“Typical”?: technological advances in bibusiness opera tions Paragraph 3: Building Sites , Construction and Installation Projects “3. A building site or construction or installation project constitutes a permanent establishment only if it lasts more than twelve months.” z Sppyyecial rule for an activity that by nature is temporary z 12 months minimum period in OECD Model, but adoption of 6 months(UN) is common z Is the construction site a PE for all contractors? z Construction or a project conducted at multiple sites z Subcontracted contracts

Article 5 (4) Activities deemed not to be a PE z “Permanen t EtblihEstablishmen t"shllhall be dddeemed not to ildinclude: a) the use of facilities solely for the purpose of storage, display or delivery of goods or merchandise belonging to the enterprise; b) the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display or delivery; c) the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise; d) the maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise or of collecting information,forthe enterprise; e) the maintenance of a fixed place of business solely for the purpose of carrying on, for the enterprise, any other activity of a preparatory or auxiliary chtharacter; f) the maintenance of a fixed place of business solely for any combination of activities mentioned in subparagraphs a) to e), Agents - Paragraphs 5 and 6

Company A

State R

State S Agent PE of Company A?

Customers

Does a dependent agent PE exist? z Not an independent agent ? z Acting on behalf of the enterprise ? (or In the name of the enterprise?) z HabituallyHabitually eexercisesxercises in tthehe State ? z An authority to conclude contracts ? z Not covered by paragraph 4 ? Paragraph 7 - Parents & Subsidiaries z A Clarification: the relationships which exist btbetween paren t an d su bidibsidiary as suc h an d between fellow subsidiaries as such do not of themse lves maktke one company a permanent establishment of another company z A subsidiary may act as the dependent agent of its parent or fellow subsidiary and its premises may be used as a fixed place of business of the parent or a fellow subsidiary - this is a question of fact

Article 23: Double Taxation Relief z Deduction method: Allowing taxpayers to claim a de duc tion for taxes pa id to a fore ign coun try z Exemption method: Providing taxpayers with an exemppgtion for foreign-source income z Credit method: Providing taxpayers with a credit against taxes otherwise payable for income taxes paid to a foreign country Comparison of Methods for Double Taxation Relief

Deduction method Exemption method Credit method

Foreign-source Income 100 100 100

Foreign Tax (40%) 40 40 40

Deduction for Foreign Tax 40 nil nil

Net Domestic Income 60 nil 100

Domestic Tax Before Credit 30 nil 50 (50%)

Less: Foreign Tax Credit nil nil 40

Final Domestic Tax 30 nil 10

Total Domestic & Foreign 70 40 50 Tax

Tax Sparing Credit (TSC)

z Concept: A credit granted by the resident country fffor forei gn t axes th thtat were not act tllidtually paid to the source country but that would have been paid un der the coun try ’s norma l tax ru les

z Without TSC, actual beneficiary of a tax incentive ppyrovided by a source countr y to attract foreign investment may be the resident country rather than the foreign investor Comparison of Effects of TSC

Credit method Exemption method Without TSC : With TSC Foreign-source Income 100+100 100+100 100+100

Foreign Tax (0 %, 30%) 0+30 0+30 0+30 Deduction for Foreign Tax nil nil nil

Net Domestic Income nil 100+100 100+100

Domestic Tax Before Credit nil 50+50=100 50+50=100 ((%)50%)

Less: Foreign Tax Credit nil 0+30=30 30+30=60

Final Domestic Tax nil 70 40

Total Domestic & Foreign Tax 30 30+70=100 30+40=70

Korea’s Treaty Policy on TSC

z Seeking TSC until 1980s when negotiating with dlddeveloped coun titries

z Chang its position when joining the OECD

z Sunset clause when revising tax treaty with developed countries

z Allowing TSC to developing countries with sunset clause and anti-abuse provisions

Training Material – Transfer Pricing

September 2011

Presented by Dr. Kyung Geun LEE

Contents

I. Introduction to Transfer Pricing

II. Arm’s Length Principle and Comparability

III. Transfer Pricing Methods

IV. Revision of OECD TP Guidelines I. Introduction to Transfer Pricing

What is Transfer Pricing?

MftManufacturer Whol esal e Parent Co. Distribution Sub Goods for Asian region

Distribution Sub for each country

EdEnd-CtCustomers ƒ Is there a transfer pricing issue? ƒ What are the risks to Businesses and Governments?

-4- Relevance of the Subject

ƒ Approximately 60-70% of the world trade carried on within Multinational Groups of Enterprises (MNEs)

ƒ Cross-bdborder dimens ion o ftf transac tions...

ƒ ...due to globalization and economies of scale

ƒ Transfer prices ... are prices at which an enterprise transfers gg,oods, services or intangible pppropert yto associated enterprises

-5-

Relevance of the Subject, cont’d

ƒ Transfer Pricing Regimes: Reliance on the Arm‘s Length Principle (ALP)...

ƒ ALP entails the Separate Entity Approach,i.e.associated enterprises are taxed as if they were dealing wholly idindepen den tly (i.e. at arm‘s lth)length)

ƒ Global formulary apportionment approach: An approach to allocate the global profits of an MNE group on a consolidated basis among the associated enterprises in different countries on the basis of a predetermined formula

-6- Transfer Pricing Adjustment

ItIntra-Group Manufacturer Transaction Distribution Subsidiary Country A Country B Costs = 100 Resa le Pr ice = 300

Intra-Group Profit A Transfer Price GrossProfit B Total Profit 50 150? 150 200 100 200? 100 200 150 250? 50 200 200 300? 0 200 250 350? -50 200

-7-

Transfer Pricing Adjustment, cont’d

Intra-Group Manufacturer Transaction Distribution Subsidiary Country A Country B Costs = 100 TfPiTransfer Price Resale Price = 300 300

Profit A = 200 PfitBProfit B = 0 TtlTotal = 200 Tax 25% = 50 Tax 30% = 0 Total = 50

ƒ Multinational Groups of Enterprise can adjust the total tax burden by adjusting the transfer price.

ƒ OECD TP guideline provides a international transfer pricing standard for MNEs and tax administrations .

-8- II. Arm’s Length Principle and Comparability

-9-

Comparability – what for? Arm’ s Length Principle ƒ Arm’s Length Price: the price which would have been agreed upon between unrelated parties engaged in the same or similar transactions under the same or similar conditions in the open market.

ƒ Definition: Article 9 (1) OECD Model Tax Convention: “(….) if conditions made or imposed between associated enterprises in their commercial or financial relations differ from those which would have been made between independent enterprises, then profits that, but for those conditions, would have accrued to one of the enterprises may be included in the profits of that enterprise and taxed”.

ƒ Commentary on Article 9 (1) Paraggpraph 2: “normal open market commercial terms”

-10- Comparability – what for Arm’s Lenggpth Principle

ƒ Transfer Pricing Regimes: Reliance on the Arm‘s Length Principle (ALP)...

ƒ ALP entails the Separate Entity Apppproach,i.e.associated enterprisesaretaxedasiftheyweredealingwholly independently (i.e. at arm‘s length)

ƒ Global formulary apportionment approach: An approach to allocate the global profits of an MNE group on a consolidated basis among the associated enterprises in different countries on the basis of a predetermined formula

-11-

What does “comparable” mean?

ƒ To be comparable means that • None of the differences (if any) between the situations being compared could materially affect the condition being examined in the methodology (e.g. price or margin), or • Reasonably accurate comparability adjustments can be made to eliminate the effect of any such differences.

ƒ “Comparable” does not mean “identical” , but the comparison must be reasonably reliable (very similar, substitutable)

-12- 5 Factors determining Comparability (para gra phs. 1.19 – 1.35 OECD Guidelines)

1. Characteristics of property/service Very 2. Functional analysis important!

3. Contractual terms 4. Economic circumstances Less important 5. Business strategies

ƒ Make appropriate comparability adjustments for any substantial differences between the compared transactions/enterprises! ƒ Determine an arm’s length range!

-13-

Arm’s length range

ƒ The application of the most appropriate method or methods might produce a range of figures all of which are relatively equally reliable arm’ s length range ƒ Differences in the figures that comprise the range may be due to: • Arm’s length principle only produces an approximation of conditions • The fact that independent enterprises engaged in comparable transactions do not establish exactly the same price • Application of more than one method

-14- Arm’s length range, cont’d

ƒ Any point in the arm’s length range satisfies the arm’s length principle ƒ If an adjustment ismade bythetaxadiidministrat ion, itshldhould be made “to the point within the range that best reflects the facts and circumstances of the controlled transaction.”

-15-

Typical Process in 10 Steps for Identifying Comparable Transactions and Using Data

Step 1: Determination of years to be covered

Step 2: Broad-based analysis of the taxppyayer’s circumstances

Step 3: Understanding the controlled transaction(s) under examination in order to choose the tested party, the most appropriate TP method, identify the relevant factors that will influence both the choice of the appropriate method(s) and the comparability analilysis

Step 4: Review of existing internal comparables, if any

Step 5: Determination of available sources of information on external comparables

-16- Typical Process in 10 Steps for Identifying Comparable Transactions and Using Data, cont’ d

Step 6: Selection of the relevant transfer pricing method(s) and, depending on the method(s), determination of the relevant indicator

Step 7: Identification of potential comparables: defining the key characteristics to be met by any uncontrolled transaction in order to be regarded as potentially comparables

Steps 5 – 7 mihtight be repeatdted

Step 8: Determination of and making comparability adjustments where appropriate

-17-

Typical Process in 10 Steps for Identifying Comparable Transactions and Using Data, cont’ d

Step 9: Interpretation and use of data collected, determination of the arm’s length remuneration

Step 10: Establish, monitor and review transfer prices

-18- III. Transfer Pricing Methods

-19-

5 TRANSFER PRICING METHODS

TRADITIONAL TRANSACTION METHODS ƒ Comparable uncontrolled price (CUP) method ƒ Cost-plus method ƒ Resale price method

TRANSACTIONAL PROFIT METHODS ƒ Transactional Net Margin Method (TNMM) ƒ Profit Split Method • Contribution Analysis • Residual Analysis

-20- Selection of TP Method

ƒ In the past, general preference for traditional transaction methods over transactional profit methods ƒ Selection process of the most appropriate method for a particular case should take account of

i) The respective strengths and weaknesses of each of the OECD recognised methods;

ii) The appropriateness of the method considered in view of the comppyarability ((gincluding functional) analysis;

iii) The availability of reliable information (in particular on uncontrolled compp)arables) needed to appl y the selected method and/or other methods;

iv) The degree of comparability of controlled and uncontrolled transactions including the reliability of comparability adjustments that may be needed to eliminate differences between them. -21-

Comparable Uncontrolled Price (CUP) Method

ƒ CUP method compares the price charged for property or services transferred in a controlled transaction to the price charged for property or services transferred in a comparable uncontrolled transaction in comparable circumstances.

ƒ Preferred method if comparable uncontrolled prices can be found

ƒ An uncontrolled transaction is comparable to a controlled transaction for purposes of the CUP method if one of two conditions is met:

• None of the differences (if any) between the transactions beinggp compared or between the enter prises could materiall y affect the price in the open market; or

• Reasonablyyj accurate adjustments can be made to eliminate the material effects of such differences.

-22- Comparable Uncontrolled Price (CUP) Method, cont’ d ƒ The fair market price for comparable goods, services or loans between indepppendent companies ƒ Difficulties in finding comparables: • Goods or Services • Market (ex. geographical differences) • Market-level (wholesale or retail) ƒ If no exact comparables Æ comparability adjustments for the differences ƒ MthdMethod can b est tb be used df for commoditi es, raw mat eri ilal, agricultural products, chemical base products, financial products (e.g. interest rates)

Associated Enterprise A Controlled transaction Associated Enterprise B Columbian coffee beans Price: 100/ton

Associated Enterprise A Uncontrolled transaction Independent Enterprise C Columbian coffee beans Price: 120/ton -23-

COST PLUS METHOD

Tested Party Multinational Enterprise Group Third Party TfTransfer Manufacturer Distributor Supplier price

Costs at Gross Profit = Transfer Arm’ s length Mark-Up Price

ƒ Calculate gross profit mark-up for manufacturer ƒ EittEasiest to appl lfy for semi-fin is he d goo ds ƒ Most useful where the tested party does not contribute valuable unique intangible assets or assume unusual risks in the controlled transaction (e.g., a contract or toll manufacturing arrangement)

ƒ -24- COST PLUS METHOD, cont’d

Example:

Manufacturing Costs $80$ 80 Determined from Gross Profit Margin (Mark-up) 25% comparable companies/transactions

Cost Mark-up on cost

Arm’s Length Transfer Price = $ 80 + ($ 80 x 25%) = $ 100

ƒ Focus on function ƒ Benchmark is comparable (arm’s length) gross profit mark-up on costs

-25-

RESALE PRICE METHOD

Tested Party

Sales Price to rd Transfer 3 Party rd Manufacturer Distributor 3 Party Price Customer Multi na tiona l Enterprise Group Sales Price to 3rd Party - Gross Profit (Resale Price) Margin Transfer Price

ƒ Calculate gross margin for distributor/reseller ƒ Easiest to apply if reseller does not add substantially to valfdtlue of product

-26- RESALE PRICE METHOD, cont’d

Example:

Sale Price to Third Parties $ 100 Determined from comparable Resale Price margin 20% companies/transactions

Sales Price Resale Price Margin

Arm’s Length Transfer Price = $ 100 - (20% x $100) = $ 80

ƒ Focus on ftifunction; useflfful for a dis tr ibu tor ƒ Benchmark is comparable (arm’s length) gross profit margin (discount)

-27-

What is a “profit method”?

ƒ Uses net profitability to judge transfer pricing

ƒ Must be Transactional • Total profit comparisons can only be used to select cases but not to examine them

-28- Transactional Net Margin Method (TNMM)

ƒ OECD TP Guidelines 2.58

• “[TNMM] examines the net profit margin relative to an appropriate base (e.g.. costs, sales, assets) that a taxpayer realizes from a controlled transaction….

• The arm’s length net profit indicator (i.e. a ratio of net profit relative to an appropriate base) of the taxpayer from the controlled transaction may be determined by reference to the net profit indicator of internal comppparables or external comparables.

• Must be applied in a manner consistent with resale price/ cost plus method

-29-

TNMM: Comparability Analysis (I)

ƒ What factors influence net profit? • Net profit may be affected by factors unrelated to transfer prices ƒ TNMM uses net profit margins, i.e. net profit margin computed after all operating expenses (except interest, taxes and extraordinary items)

ƒ Examine factors affecting operating expenses • Managgyement efficiency • Competitive position • Business experience • Varying cost structures

-30- Difference between TNMM & Resale Price Method

• Sales revenue (sales to independent customers) 1,000 • Cos t of good s sold (purc hases from assoc ia te d en terpr ise ) (400) • Gross profit (e.g. 60% of sales) 600 (←RPM) • Selling and other operating expenses (400) • Operating profit (e.g. 20% of sales) 200 (←TNMM) • Financial items +10 • Exception items (30) • Pretax profit (EBT, earnings before taxes) 180 • Income tax (60) • Net profit 120

-31-

Difference between TNMM & Cost Plus Method

• Cost of raw materials 200 • Other direct and indirect production costs 100 • Total cost base 300 • MarkMark--upup on Costs (e.g. 20% of costs) 60 (←CPM) • Transfer price 360 • Overheads and other operating expenses (45) • OOtifit(5%ft)perating profit (e.g. 5% of costs) 15 15( (←TNMM)

-32- TNMM: Example

Tested Party Multinational Enterprise Group Third Party Transfer Provider Recipient Supplier price

Selected Net Profit Indicator: Full Cost Mark Up

Total Cost (COGS + 1 + Net Profit Mark Up = Transfer Price Operating Expenses)

ƒ Easiest to apply for • Services

-33-

TNMM: Example, cont’d

Example:

COGS $ 100 Operating Expenses $ 50 Determined from Net Profit Mark Up Ratio 10% comparable companies /transactions

Total Cost (COGS + 1 + Net Profit Operating Expenses) Mark Up

Arm’s length Transfer Price = ($100 + $50) X (1+10%) = $ 165

-34- Profit Split Method

ƒ Where transactions are very interrelated: they cannot be evaluated on a separate basis

ƒ Under similar circumstances, independent enterprises may decide to set up a form of partnership and agree to aformof profit split

ƒ Also a transactional method

ƒ 2 types of profit split method • Contribution Analysis (total profit split) • Residual Analysis (residual profit split)

-35-

PS: Contribution analysis

ƒ Compute combined net profit

ƒ Examine functions

ƒ Determine relative value (value added) • SftSome factors: expenses i ncurred , asset s used , payroll

ƒ Examine external data

ƒ Assign a profit split percentage

-36- PS: Residual analysis - 2 Step approach

ƒ Compute combined net profit of associated enterprises and examine functions performed (routine and non-routine) Step 1 Use other methods (CUP, Cost Plus, Resale Price, TNMM) to assign basic return to each (routine) function of each company • Often can assign profit from activities not involving significant intangible property • Examples: distribution function (resale price); manufacturing function (cost plus), possibly some TNMM applications Step 2 Divide residual profit according to a contribution analysis • R&D and/or marketing expenditures may be relevant

-37-

PS: Example (Total Profit Split)

Tested Party TtdPtTested Party Multinational Enterprise Group rd Third Party TfTransfer 3 Party Participant A Participant B Supplier price Customer Combined Net Profit

Combined Net Contribution Ratio of Arm’s length Profit = Profit Participant A of Participant A

Combined Net Contribution Ratio of Arm’s length Profit = PfiProfit Participant B of Participant B

-38- PS: Example (Total Profit Split), cont’d

Example:

Combined Revenue $ 300 Determined from Combined Expenses $ 150 comparable companies Combined Net Profit $ 150 /transactions or Contribution Ratio of Participant A 60% relative value of functions performed by each tested CtibtiContribution RtiRatio of Parti ci pan t B 40% party

Contribution CbidPfitCombined Profit Ratio

A’lthPfitArm’s length Profit = $ 150 X 60% = $90$ 90 of Participant A Arm’ s length Profit = $ 150 X 40% = $60$ 60 of Participant B

-39-

IV. Revision of OECD TP Guidelines

-40- Revision of OECD TP Guidelines

ƒ The OECD has released a new Transfer Pricing guidelines revising part Chapter I~III and inserting Chapter IX on Business Restructuring.

ƒ The main changes on Chapter I~III are as follows; • Hierarc hy o f Trans fer Pr ic ing me tho ds • Comparability analysis • Guidance on the application of transactional profit method; and • Annexes

-41-

Hierarchy of TP methods

ƒ In theprevious guide line, there are two catitegories of OECD- recognized TP methods; • Traditional transaction methods; and • Transactional profit method

ƒ In the past, transactional profit method (TNM, PS) had a status of last resort methods, to be used only exceptional cases where there are no or insufficient data available.

ƒ The OECD removed exceptionality and replaced it with a standard whereby the selected transfer method should be the most appropriate method to the circumstances of the case.

-42- Thank you

The publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You s hou ld no t ac t upon th e in forma tion contained in this publication without obtaining specific professional advice.

No representation or warranty (expressed or implied) is given as to the accuracy or completeness of the information contained in this publi ca tion.

-43- Training Material – TfPiiCStdTransfer Pricing Case Study

September 2011

Presented by Dr. Kyung Geun Lee



Contents

I. Movie/Video distribution

II. Pharmaceutical I. Movie/Video Distribution

1. Understanding of the industry

2. BkBackground

3. TP adjustment by the tax authority

4. Key issues

5. Implication

I. Movie/Video Industry 1. Understanding of the industry

Structure of the movie distribution in Korea

Investment Production Distribution Showing

Financial Marketing Dist. Game Institution Capital Agency Mobile Small and medium Movie Direct Prod Print enterprises delivery to Theater ucer Video promotion the whole Internet Screen company country or region Internet New Studio Distributor Media DVD

Large Enterprise Cable Capital TV

* Source: [Structure of the movie industry in Korea] Movie promotion committee, 2002

Slide 4 I. Movie/Video Industry 1. Understanding of the industry

Copyright • In relation to movie rights, copyright is the biggest asset • The copyri ght initiall y belon gs to the production com pan y, thou gh the distribution company recently tends to exercise rights on behalf of the production company through a transfer of the copyright, and shares profit

License agreement • Movie transactions (i.e., import and distribution) are generally conducted via a license agreement. These transactions require that a royalty is paid to the license holder.

Royalty types • Flat deal : pays a certain amount of royalty per each movie • Minimum guarantee : pa ys a minimum guarantee fee initiall y, then a runnin g guarantee is applied based on the copyright usage fees for different channels

Slide 5

I. Movie/Video Industry 2. Background

Company and transaction summary

• Company - United International Pictures Inc. (()“UIP”) established in 1988 via 50:50 joint investment of United International Pictures BV (“UIPBV”), a Dutch movie distribution company, and Cinema International Pictures BV (“CIBV”), a video distribution company • Transaction summary - The Company (plaintiff) received movies and videos from UIP and CIC Video Int ernati onal (“CVI”) an d pa id roya lties • The Company paid a following portion of its revenue as royalties for FY1990 and FY 1991 Classification FY 1990 FY 1991 Movie (paid to UIP) 69.47% (51.91%) 59.92% (49.82%) Video (idtCVI)(paid to CVI) 51. 13% (49. 41%) 57. 89% (47. 12%)

Slide 6 I. Movie/Video Industry 2. Background

Transaction structure

Netherland

UIPBV (Joint-Investment) 50% (Joint-Investment) CIBV 50% UK Movie UIP Royalty Company Video CVI Royalty

Slide 7

I. Movie/Video Industry 3. TP adjustment by the tax authority

• The tax authority determined the arm’ s length price based on the Comparable Uncontrolled Price (“CUP”) method • The Company proposed the following as comparable transactions - Movie: a percentage of the royalty (that Pan Asia Ltd., an independent enterprise in Hong Kong, has paid to UIP) out of the total sales amount - Video: a ppgercentageoftheroyyyalty (that King Video Ltd., an independent enterprise in Taiwan, has paid to CVI) out of the total sales amount • The tax authority determined the arm’s length price by averaging the percentage of royalty paid in comparable transactions proposed by the Company and those of the following domestic comparable transactions: - The percentage of royalty that domestic movie distributors Woo-jin Film (movie) and SKC (video) have paid to unrelated movie distributors • The tax authority determined a portion that exceeds comparables' royalty rates as non-deductible.

Slide 8 I. Movie/Video Industry 4. Key issues

1) Comparability of the companies selected by the tax authority

• Company - Transactions of Woo-jin film and SKC have no comparability with the Company’s transactions with foreign related parties, thus both should not be considered as comparables

• Tax authority - A percentage of royalties paid to Fan Asia (movie) and King Video (video) from the comparabl es propose d by the Company do no t re flec t the geographi ca l an d cultural differences from Hong Kong and Taiwan, thus domestic comparables (Woo-jin and SKC) should be added to comparables

Slide 9

I. Movie/Video Industry 4. Key issues

1) Comparability of the companies selected by the tax authority (Cont’ d)

• Court decision - Movie:appgercentageofroyyyalty for Woo-jin and those of the Comppyany are not comparable as per the following points: 1) Quality of the movie: movies Woo-jin has imported/distributed are only 1/2.7 o f t he Co m pan y’ s in terms o f av er age n um ber of audi en ces an d average profit 2) Payment method: the Company implements regular royalty payment method, whereas Woo-jin pays the set amount of royalty based on a prearranged agreement regardless of the performance results - Video: No material difference in quality exists between videos the Company has impor te d/dist rib ut ed and those SKC has impor te d/dist rib ut ed . FthFurther, even though a slight difference exists in the payment method of box office profit and royalty, this minor difference could be due to geographical and economical conditions which affect the determination of royalty. Therefore, a high level of comparability exists.

Slide 10 I. Movie/Video Industry 4. Key issues

2) Method in determining the arm ’ s length price

• Company -Ascomparable transactions also include other foreign transactions with Israel and , it is deemed appropriate to use the inter-quartile range in determining the arm’s length price • Court decision - If there is a transaction conducted under the same conditions as the controlled transaction or does not require adjustment, it is sufficient to compute the arm’s length price using this transaction’ s figures – no need to add other data - Provided that the tax authority has used the requisite amount of effort to collect data in determining the arm’s length price range and the result is deemed rationa l, then the taxpayer has the bdburden toprovethat theprice it has used in inter-company transactions falls within that range - Furthermore, it is not appropriate to consider the arm’s length price determined by the tax authorit yasaviltiiolation of law only bdbased on the ground that thearm’s length price proposed by the taxpayer is more rational Slide 11

I. Movie/Video Industry 5. Implication

• In case a difference (e.g., transaction condition) exists between the controlled transaction and comparable transaction based on the CUP method, ‘rationality’ was proposed as a standard to adjust such difference

• The following has to be taken into consideration in selecting comparable transactions of the movie/video industry: (1) quality of the movie/video (2) payment method of royalties (3) box-office record (4) geographic condition and (5) economic condition, etc.

• If it is considered that the tax authority has put its best effort to collect data in determining the arm’ s length price and the result is deemed rational, then the taxpayer has the burden to prove that the arm’s length range can be obtained using multiple comparables and that the price it has used for inter-company transactions falls within that range.

• It is inappropriate to consider that the arm’s length price determined by the tax authority as violation of law only based on a ground that the arm’s length price proposed bythe taxpayer is more ratilional

Slide 12 II. Pharmaceutical

1. Understanding of the industry

2. BkBackground

3. TP adjustment by the tax authority

4. Key issues

5. Implication

II. Pharmaceutical Industry 1. Understanding of the industry

1) Characteristics of the pharmaceutical industry • High risk- high development expense, long development period, and difficult to predict the success rate • Shortened period for competitors’ introduction of new products • Profit generation strategy a. Focus on development of a new medicine →excessive investment, high risk b. Exploit the niche market (e.g., customizable new medicine) c. Capture market opportunity via modeling (fast follower)

2) Generic market • Generic : medicine which offers the same function and effect as new medicine • Approval condition: equality, safety, effectiveness • Same approval condition as with the development of new medicine → low effect of cost reduction

Slide 14 II. Pharmaceutical Industry 2. Background

1) Basic background

• Glaxosmithkline Inc. (“Glaxo Canada”) is a 100% owned subsidiary of Glaxo Group •Glaxo Grouppyg is a 100% owned subsidiary of Glaxo Holdings PLC • Glaxo Holdings is a global pharmaceutical company which discovers, develops and manufactures medical supplies and then sells them globally • Sales of medical supplies are conducted through subsidiaries of Glaxo Group or local distributors • Ranitidine is an Active Pharmaceutical Ingredient (“API”) and the Company sells Zantac, a treatment medicine for ulcers , in Canada • Apotex Inc, Novopharm Ltd. (“Generic”) is a company which manufactures medical supplies after paying royalties to a party holding the patent, and was selling Ranitidine in Canada at the time • Sales of Ranitidine in Glaxo Europe was conducted through third party licensees in many countries • Key issue is the arm’s length nature of the price at which Glaxo Canada purchased Ranitidine from its related parties for 1990~1993 Slide 15

II. Pharmaceutical Industry 2. Background

2) Facts

• Glaxo Pharmaceuticals (Pte) Limited is a Singapore-based entity which initially manufactures Ranitidine • Adechsa S.A is a Switzerland-based clearing company of Glaxo • Glaxo Pharmaceuticals (Pte) Limited sells Ranitidine to Adechsa S.A, and Glaxo Canada purchases from Adechsa to sell in Canada • Glaxo Canada’s purchase prices from Adechsa and generic companies’ purchase prices from third parties during the tested period are as follows: (Unit: USD) Purchase Price Year Glaxo Canada Generic Companies 1990 1, 512 /kg 292 ~ 304 /kg 1991 1,575/kg 244 ~289 /kg 1992 1,635/kg 220 ~ 253 /kg 1993 1,651/kg 194 ~ 248 /kg

Slide 16 II. Pharmaceutical Industry 2. Background

3) Transaction structure

Glaxo Holdings PLC 100%

Glaxo Group Ltd Glaxo Far East 100% (Pte) Ltd License agreement ② Sales of Ranitidine (Controlled Transaction) ① Ranitidine Sales Glaxo Glaxo Canada Adechsa S.A Pharmaceuticals (Company) (Switzerland) (Pte) Limited

Supply Agreement

Slide 17

II. Pharmaceutical Industry 3. TP adjustment by the tax authority

• The tax authority selected generic companies’ purchases of Ranitidine from third parties as comparable transactions in determining Glaxo Canada’s income for the tested period

•As the p ri ce at whi ch th e Com pan y h as pur ch ased R ani ti din e fr om i ts r el ated parties exceeded the highest price among the generic companies’ purchase prices, the tax authority adjusted Glaxo Canada’s purchase prices by the amount of which exceeded the ppppprices applied to comparable transactions in calculatin g its taxable income

TP adj ust ment = (C ompany’ s purch ase pri ce – PhPurchase pri iice in comparable transaction) X Transaction volume

Slide 18 II. Pharmaceutical Industry 4. Key issues

1) Selection of TPM and comparable transactions

Category Company’s position Tax authority’s position Pri mary me thod : CUP Pri mary me thod : CUP TPM Secondary method: TNM Secondary method: CP Purchase of Ranitidine by CblComparable Glaxo’s licensee distributors in Purchase of Ranitidine by generic companies Transaction European Region

- Glaxo group performs strict - Europppean Licensees are not comparable due quality control by meeting to regional differences internal production quality - As Glaxo pays separate promotion support standards and subsidyypy to licensees, comparability is Reason - As such, Glaxo’s products are low of a higher quality than generic - Difference exists as European Licensees products and comparability retain 60% of the gross profit based on the dtitdoes not exist contracts with Glaxo

Slide 19

II. Pharmaceutical Industry 4. Key issues

2) Issues in applying the CUP method

Category Company’s position Tax authority’s position Consideration ­Should take both supply contract ­Each contract is separate and should of License and license contract into be based on the supply contract Contract consideration ­Comparability does not exist ­BiBusiness c ircums tance has no between the Company’s Reasonable relevance with a TP analysis and transactions and generic Circumstance does not affect determination of the company’s transactions due to appropriate price different b usi ness c ircums tances ­Quality and production control do not Quality and ­Glaxo Group products offer better have much effect on product quality Production quality due to its strict quality and Control ­NdiffNo difference ex itbtists between the production control Standard Company’s products and generic products → The Court has decided in favor of the tax authority

Slide 20 II. Pharmaceutical Industry 4. Key issues

3) TP adjustment by the court • In relation to Glaxo Canada’ s purchase transactions of Ranitidine , the Tax Court determined purchase prices of generic companies (i.e., comparable transactions) to be the arm’s length price (May 2008). • TP adj ust ment amount was comput ed t o b e th e diff erence b et ween Gl axo Canada’s purchase prices and generic companies’ purchase prices. - Though there were differences between Ranitidine purchased by Glaxo Canada and Ran itidine purc hase d by gener ic compan ies, there was no t su ffic ien t proo f tha t quality control contributed to the differences and, as such, no adjustment was made.

• The Federal Court of Appeal (Appeal Court) overturned the Tax Court’s decision (July 2010). → Sending the case back to the Tax Court for a redetermination of the appropriate arm's-length price • Appeal Court held that the License Agreement should be considered conjointly with the cost of the ranitidine. •Appeal Court acknowled ged that the si gnificant brand power associated to the dru g affords the Glaxo Group a great deal of bargaining power when negotiating transfer pricing transaction. Slide 21

II. Pharmaceutical Industry 5. Implication

• In applying the CUP method, this case demonstrated the technical application of methods highlighted in the OECD guidelines such as ‘Economic Comparability’, ‘Comparability of Commodities’, and ‘Contract Conditions’

• In evaluating the arm’s length nature of purchase transactions, a comprehensive examination of all relevant facts as well as the entirety of taxpayer’s business modldel must tb be und ertktaken i nordtdtider to determine a re libltliable trans fer pr ice.

Slide 22 Thank you !